Basel III could facilitate the emergence of non-bank sources of hedge fund financing as prime brokers increasingly retreat because of capital requirements.
Basel III Liquidity Coverage Ratios (LCR) forces banks to hold sufficient high quality liquid assets (HQLA) to a weather a 30 day market stress event. Basel III also seeks to reduce the risk of liquidity mismatches and over-reliance on short term funding at banks through its Net Stable Funding Ratio (NSFR). Hedge fund cash parked at banks is considered short-term as it is likely to be pulled out in times of crisis. As such, banks must hold more capital when holding hedge fund cash.
This is leading to a number of prime brokers re-evaluating their business models, and even terminating relationships with hedge funds which do not generate much business, or have not sufficiently grown their Assets under Management (AuM).
A number of prime brokers are also scaling back financing, which could have a major impact on hedge fund returns, particularly at strategies dependent on leverage or which are invested into illiquid assets. In 2012, Barclays Prime Finance estimated the average hedge fund could see returns drop between 10 bps to 20 bps if prime brokerage financing was restricted.
“We could see hedge funds lending unencumbered assets to other hedge funds, with prime brokers acting as intermediaries. This could potentially be a new source of capital and could help hedge funds with their financing,” said Mario de Bergolis, head of operational due diligence and business management at Standard Life Investments, speaking at the GAIM Ops Conference in Dublin.
Another potential source of financing could be private equity, which is currently sitting on huge amounts of dry powder and under growing pressure to find profitable deals in an expensive equity market. However, prime brokers point out that hedge funds and private equity often lack the operational and technological resources to provide financing. Nonetheless, a number of larger hedge fund managers are bolstering their treasury functions and capabilities, and this could eventually lead to intra-hedge fund financing.
One unintended consequence of Basel III is that it could force hedge funds to reduce the number of prime brokers they use, which could facilitate an increase in counterparty risk. One investor said he did not want hedge funds to revert to the single prime brokerage model, and highlighted mid-tier and mini prime brokerage outfits could emerge, some of whom will not have significant balance sheet capital. Again, this could increase risk, added the investor.
Prime brokerage is not the lucrative business it once was. Credit Suisse has dramatically shrunk its prime brokerage unit. Others including Goldman Sachs and Bank of America Merrill Lynch have exited struggling or small hedge fund clients. One hedge fund manager predicted a number of banks would shut down their prime brokerage businesses within the next few years.